Financing the entrepreneurial venture

Abstract

We model financial contracting in entrepreneurial ventures. In our incomplete contracts framework, the entrepreneur can design contracts contingent on three possible control right allocations: entrepreneur control, investor control, and joint control, with each allocation inducing different effort levels by both the entrepreneur and the investor. We find that a variety of contracts resembling financial instruments commonly used in practice, such as common stock, straight and convertible preferred equity, and secured and unsecured debt, can emerge as optimal, depending on two key factors: entrepreneur/investor effort complementarity and investors' opportunity cost of capital. The results of our model are consistent with, and yield new explanations for, empirical regularities such as (a) the prevalence of equity-type contracts in high-growth ventures and of debt-type contracts in lifestyle ventures; (b) geographical and temporal differences in equity-type instruments used in high-growth ventures; and (c) the impact of firm and loan characteristics on the choice between secured and unsecured debt. © 2008 INFORMS.